Stocks — Part XXIV: RMDs, the ugly surprise at the end of the tax-deferred rainbow

Someday, if all goes well and you haven’t already, you’ll wake up to find you’ve reached the ripe old age of 70 1/2. Hopefully in good health, you’ll rise from bed, stretch and greet the new day happy to be alive. You’ve worked hard, saved and invested, and now are contentedly wealthy and secure. Since you’ve diligently maxed out your tax-advantaged accounts, much of that wealth might well be in those, tax deferred for all these years. On this day, if you haven’t already, you’ll begin to fully appreciate the “deferred” part of that phrase. Because your Uncle Sam is waiting for his cut and he figures he’s waited long enough.

Except for the Roth IRA, all of the tax-advantaged buckets discussed in Part VIII of this series have RMDs (required minimum distributions) as part of the deal and these begin at age 70 1/2. This includes Roth 401k and 403(b) plans. Those you can and should roll into your Roth IRA the moment you get a chance anyway.

Basically this is the Feds saying “OK. We’ve been patient but now, pay us our money!” Fair enough. But for the readers of this blog who are building wealth over the decades, there may well be a very large amount of money in these accounts when the time comes. Pulling it out in the required amounts on the government’s time schedule could easily push us into the very highest tax brackets.

Make no mistake, once you reach 70 1/2 these withdrawals from your IRAs, 401Ks, 403(b)s and the like are no longer optional. Fail to take your full distribution and you’ll be hit with a 50% penalty. Fail to withdraw enough and the government will take 50% of however much your short fall is. That’s right, they will take half of your money. This is not something you want to overlook.

The good news is that if you hold your accounts with a company like Vanguard, they will make setting up and taking these distributions easy and automatic, if not painless. They will calculate the correct amount and transfer it to your bank, money market, taxable fund or just about anyplace else you chose and on the schedule you chose. Just be sure to get the full RMD required each year out of the tax-advantaged account on time.

Just how bad a hit will this be? Well, there are any number of calculators on-line and you can plug-in your exact numbers for an accurate read of your situation. Vanguard has their own, but so do companies like Fidelity and T. Rowe Price. To give you an idea of what the damage might look like, I plugged into Fidelity’s to provide the following example.

You’ll be asked your birth date, the amount of money in your account as of a certain date they specify (12/31/13 when I did it) and to select an estimated rate of return. I chose January 1, 1945, $1,000,000 and 8%. No, those are not my real numbers. In a flash the calculator gave me the results year by year. Here’s a sample:

Year RMD Age Balance

2015 $39,416 70 $1,127,000

2020 $57,611 75 $1,367,000

2025 $82,836 80 $1,590,000

2030 $116,271 85 $1,742,000

2035 $154,719 90 $1,750,000

The good news is that even with these substantial withdrawals, the total of our account will continue to grow. Of course, as we’ve discussed before, these are estimated projections. The market might do better or worse than 8% and it most certainly won’t deliver 8% reliably each year on schedule.

The bad news is, not only do we have to pay tax on these withdrawals, the amounts could push us into a higher tax bracket. Or two. This, of course, will depend on how much income you have rolling in from your other investments, social security, pensions and the like.

To give you a frame of reference, here are the tax brackets for 2014:

0 to $18,150 — 10%

$18,150 to $73,800 — 15%

$73,800 to $148,850 — 25%

$148,850 to $226,850 — 28%

$226,850 to $405,100 — 33%

$405,100 to $457,600 — 35%

over $457,600 — 39.6%

Based on this we can see that, even with no other income, by age 90 our taxpayer’s RMD of $154,719 will put him in the 28% tax bracket even without considering any other income.

And that’s based on starting with only $1,000,000. Many readers applying the principles on this blog and starting in their 20s, 30s, 40s and maybe even 50s can easily expect to have several multiples of that by the time they reach 70 1/2.

Something important to note here, and that confuses many people, is that this doesn’t mean he pays 28% of the full $154,719 in taxes. Rather he pays 28% only on the amount over the $148,850 threshold of the bracket. The rest is taxed at the lower brackets on down. Should his other income bump him over the $226,850 threshold for the 33% bracket by, say, one dollar, he will only pay 33% in tax on that one dollar.

Of course, if you think of the RMD as the last money added, that is the money taxed at the highest rate. For instance, if he has $73,800 in other income, taking him right up to the 25% bracket line, any amount of RMD will be taxed at 25% or more.

It is worth noting that all of this is before any other deductions and exemptions, and those serve to reduce your taxable income. While looking at all the possible variations is a discussion beyond the scope of this post, we can consider an example. For 2014 a married couple gets a standard deduction of $12,400 and personal exemptions of $7900 ($3950 each). In effect this means they don’t reach the 25% bracket until their AGI (adjusted gross income) reaches $94,100. ($94,100 – $7900 – $12,400 = $73,800)

So is there anything to be done?

Possibly.

Assuming when you retire your tax bracket drops, you have a window of opportunity between that moment and age 70 1/2. Let’s consider the example of a couple who retires at 60 years old, using the numbers above. They have a 10 year window until 70 1/2 to reduce their 401k/IRA holdings. They are married and filing jointly. For 2014:

The 15% tax bracket is good up to $73,800.

The personal exemption is $3950 per person or $7900 for our couple.

The standard deduction is good for another $12,400.

Add all this together and they have up to $94,100 in income before they get pushed into the 25% bracket.

If their income is below this $94,100 they might seriously consider moving the difference out of their IRA and/or 401k and taking the 15% tax hit. 15% is a very low rate and worth locking in, especially if 10 years from now their tax bracket could be twice that or more. True they lose the money they pay in taxes and what it could have earned (as we saw with the Roth v. deductible IRA discussion in Part VIII), but we are now only talking about ten years instead of decades of lost growth.

So, if they have $50,000 in taxable income they could withdraw $43,700. They could put it in their Roth, their ordinary bucket investments or just spend it. Rolling it into a Roth would be my suggestion and is in fact what I am personally doing.

You don’t have to wait until you are 60 or even until you are fully retired to do this. Anytime you step away from paid work and your income drops, this is a strategy to consider. Especially if you find yourself in the 0%-10% tax brackets. This is a variation of the Roth Conversion Ladder the Mad Fientist shared with us in Part XX. However, remember the further away from age 70 1/2 you are, the more time you give up during which any money you pay in tax today could have been earning for you over the years.

There is no one solution. If as you approach age 70 1/2, your 401k/IRA amounts are low, you can just leave them alone. If they are very high however, starting to pull them out even at a 25% tax bracket might make sense. The key is to be aware of this looming required minimum distribution hit so you can take it on your own terms.

One final note. We’ve touched a bit on tax laws in this post. While the numbers and information is current as of 2014, should you be reading this a few years after publication, they are sure to have changed. The basic principles should hold up for some time, but be sure to look up the specific numbers that are applicable for the year in which you are reading.

Addendum 1:

In the comments below, Kenneth points out that Roth 401k and 403(b) plans DO have RMDs, unlike Roth IRAs. The solution is to roll your Roth 401k into your Roth IRA as soon as the opportunity presents itself. One more, of many, reasons to move from your employer based plans as soon as you are able.

Reader Sean points out in the comments an exception to the age requirement, and his explanation is much clearer than the IRS FAQ he cites as his source:

Hi Mr. Collins – just thought I would point out that there is a way to defer taking RMDs out of your employer’s 401(k) plan.

The IRS code allows someone who is over 70.5 to defer taking RMDs if he or she is not a 5% (or greater) owner of the employer and still a current employee. Note that the plan’s legal document must allow for this (it is an employer option to write this into the plan’s legal document, and most do this – but it is always good to check with this much money, taxes, and a potential for 50% penalty on the line.)

So if you continue to work for an employer past age 70.5, and you have no ownership in the employer, you could choose not to have these withdrawals, if you plan allows.

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Comments

One thing you didn’t mention. Although Roth IRAs don’t have RMDs, if people have Roth 401Ks or Roth 403bs, the amounts in them will also be included in RMD requirements. But you can easily remove them from the calculations by transferring them into a Roth IRA account at basically no cost.

Are their annual limits to how much you can convert from a regular IRA to a Roth IRA? I understand that you pay taxes at whatever your highest marginal rate is in the year you convert but I cannot recall, and my cursory research has not revealed, whether anything like the $5500/$6500 annual limits for regular contributions apply when you are converting. My guess is that there is no limit because you do pay taxes when you convert, but I’m wondering if you can confirm that matches your understanding.

Hence, if you wanted to convert the full $43k in your example, or even a larger amount, you could.

There aren’t limits on IRA to Roth IRA conversions. You just need to pay taxes on the amount as regular income. So for most folks there is a practical limit of “Amount that keeps you under the tax bracket you expect to be in retirement”.

It’s a great way of accessing that tax deferred money without ever paying taxes on it.

However, I’d say that if your plans are long term I wouldn’t put all my chips on this color. I don’t _think_ that congress or the IRS will close the conversion pipeline loophole… but they could. Make sure you have other options that will still keep you in food and heating oil 🙂

Another quality piece, Mr.Collins. I’m placing you next to MMM & The Mad Fientist on the Mount Rushmore of financial bloggers with an ER/FI tilt. As the “elder statesman”, perhaps you’re the equivalent of the great George Washington. 🙂 At any rate..having read and re-read many of your posts, particularly of late….one thing is becoming quite clear to me. There are true financial reasons to step aside from work earlier than later not to mention the many personal reasons. Thanks for doing what you do. If you ever teach an English class at a community college or the like…sign me up. 🙂

At age 30, this all seems about as real as Star Trek. 🙂 It does go to show though how much eventual taxes a person will avoid if they retire early, life frugally, and convert their tax deferred savings to roth while in the 0 to 10% tax bracket.

I’m guessing their isn’t a charitable giving angle here? Tax savings to you would be the same whether you gave directly out of the IRA and never paid taxes vs. taking the RMD, paying taxes, and taking a charitable deduction.

Poking around on the internet there doesn’t seem to be much you can do about RMDs other than convert to a Roth slowly over time if you are in a favorable tax bracket. Some people advocate marrying a much younger spouse 🙂

There is one other consideration that might become very important. The standard deduction, exemption, and tax brackets change when one of the married couple passes away. We are recharacterizing our IRA to a Roth to keep taxes lower for the surviving spouse in old age.

This is also why I plan to delay taking my Social Security until I’m 70 and it reaches the max amount. Mine is the larger SS and once I’m gone my wife can take it over. She is likely to outlive me by a couple of decades.

Plus it will help when she marries that much younger spouse as suggested above. 😉

I intentionally left the 4th “mug spot” open…although there are some up and coming contenders no doubt. If I’m unable to audit your proposed course..( no doubt due to a spotty transcript ).. I will gladly “settle” for a rumored book release by Professor Emeritus J.L Collins. 🙂

Great info, thanks for all you do to keep us up to date! I have a question, my wife and I are both in our early 60s and still working. Should we be maxing out by putting as much of our paychecks into our Roth accounts since there is no issue from withdrawing from them if need be at our age? Thanks for your help!

Depends on your tax bracket, now and when you retire, and the number of years you plan to work.

Since a Roth requires you fund with after tax dollars, some of your money goes to paying that tax. This money, and all the money it could have earned, is lost to you forever. In exchange, you get tax-free withdrawals.

Since you can deduct your IRA contribution, you get to keep all your money working for you, but you have to pay tax when you withdraw.

At age 30, going with a Roth costs decades of lost growth from the tax paid. At your age, presumably only a few years.

If your bracket is 25% or higher, I’d still use the deductible IRA. 15% or lower and I’d consider the Roth.

But those are the broadest of suggestions and you’ll need to filter them thru your actual situation.

This isn’t exactly the best place for this question, but it spurred my memory to ask it here. If it’s previously been discussed, please just point me in the proper direction.

Are there any speculations on how protected our Roth IRA funds will be from taxation in the future?

Given that the Roth IRA was established in 1997 (signed into law just fifteen short days before my seventeenth birthday), I am part of the early generation of Roth account holders that will benefit from this tax-advantaged investment strategy for most, if not all, of my earning career. For the investor, it’s a great program on paper. Pay tax now and grow your money tax free. For the government, it seems like a fairly good deal, accept taxes now at a higher rate than would be collected in the future. The thing is, the government isn’t using those revenues wisely now. Thus, my fear is that the government will realize a huge income loss when those of us who have invested in Roth’s for our entire careers leave the workforce and, effectively, cease paying income tax altogether, somewhere around 2040. And we all know that the government won’t sit idly by and realize a huge income loss. So, what is my protection that I’m not going to pay taxes now AND later?

Further, because I’m the suspicious type, and the tax advantages of a Roth are so attractive, I start thinking about what might go wrong. Especially since these are such long-term investments and the government can and does change the rules seemingly on a whim. Two things occur to me:

1. The government can simply change the rules and declare money in Roths taxable. But since Roths are becoming so popular and are held by so many people this seems more and more politically unlikely.

2. The government can find an alternative way to tax the money. Increasingly in the USA there is talk of establishing a national sales tax or added value tax. While both may have merit, especially as a substitute for the income tax, these would effectively tax any Roth money as it was spent. This seems more likely to me.

If there’s one thing I’ve learned in my arguably short existence, it’s never underestimate the government. As the saying goes, the two certainties in life are death and taxes.

I suppose the safe way to look at it is to assume you’re going to pay taxes on your earnings in some form or fashion. Currently, I pay approximately 50% in local, state, and federal government imposed taxes and fees and only 22% (effectively) is federal income tax.

My goal is to diversify my investments such that I have choices in the future. Who knows what will happen in another twenty six years…

Hi Mr. Collins – just thought I would point out that there is a way to defer taking RMDs out of your employer’s 401(k) plan.

The IRS code allows someone who is over 70.5 to defer taking RMDs if he or she is not a 5% (or greater) owner of the employer and still a current employee. Note that the plan’s legal document must allow for this (it is an employer option to write this into the plan’s legal document, and most do this – but it is always good to check with this much money, taxes, and a potential for 50% penalty on the line.)

So if you continue to work for an employer past age 70.5, and you have no ownership in the employer, you could choose not to have these withdrawals, if you plan allows.

So if you find yourself with 7 figures in 401 (K) and IRA accounts, the solution might be to simply get a job somewhere else, roll that money into the employer 401 (k) and keep it compounding. I wonder if there is a requirement for minimum number of hours employed?

Otherwise, I might sign up to work as a greeter in Wal-Mart for free, given all the taxes I would be saving by working there. If anyone could point me to evidence as to number of hours one needs to work at the employer they don’t own 5% of, I would greatly appreciate it!

To confirm, one can roll his Roth 401K into his Roth IRA with no penalties or income limits etc? I have a Roth IRA but cannot add to it due to being past the income limits. I max out my 457 at work but was thinking about starting the Roth 401k that is offered. Am I limited on that as well since I max out my 457 to include the catch up provision since I am past 50 years old? I’m looking to continue tax sheltered investing past my 457 and looking to understand my options. Great job on your website…read it all the time sir.

Yep, you can roll a 401k Roth into an IRA Roth no problem, but only after you leave your employer. Same rules as a regular 401k into a regular IRA. However, if you roll a regular 401k into a Roth IRA it is a taxable event.

Great Article, now one point on the exemptions in your example. If you are over age 65 you get an extra exemption of $1,200, possibly $2,400 if you and a spouse are both over that age. Just a little more tax free money helps out!

In order to be useful a retirement calculator must compute the order and magnitude of saving account withdrawals, including the personal income tax consequences therein. Asking the user to input these values is unrealistic.

You say that in your example, the taxpayer’s RMD is going to push him/her into the 28% bracket by age 90. But those are in reference to the 2014 brackets. The brackets are adjusted for inflation every year.
Though I guess this all goes away if you assume its 8% returns on top of inflation. Is that what you intended?

It seems to me that the RMD issue is of concern only when a Federal (or state for that matter) increase is anticipated or it is desired to leave a substantial estate in a tax advantaged account. If the retiree is actually living off of her retirement savings then her withdrawals are going to substantially exceed her IRA’s RMD, even when her IRA is her only savings. Last summer Rob Bertram suggested i-orp.com where the RMD issue can be explored in excruciating detail.

Generally speaking the retiree’s decision making is concerned with this year’s withdrawal, made in the context of a strategic plan. Congressional meddling with the tax code is not all that important in a strategic sense since withdrawals are determined annually, based on current tax rates among other things.

I have another question, with the ROTH IRA I believe when you open them the money (interest/dividend) earned has to stay invested for 5 yrs or there is a penalty? Is this correct? Does your age make a difference in this requirement? Say over 59 1/2? If you already have roth ira’s can you just transfer the money into those existing accounts? Thanks!

–Money you contribute to a Roth can be withdrawn anytime, tax and penalty free.
–Money you roll into a Roth from an regular IRA can be withdrawn tax and penalty free after five years.
–The money that money earns, is tax & penalty free once you reach 59.5

In short, you can no longer contribute to a Traditional IRA once you reach 70.5

However, as long as you meet the regular requirements like having earned income, you can contribute to:

—Roth IRA.

—Roth 401(k)

—Traditional 401(k)

If you go the 401(k) route and your plan allows for it (check carefully), you might consider rolling your existing T-IRAs and other 401(k)s into it. Doing so can protect them from the RMD until you leave your employer. However, carefully consider the investment options in your plan before doing this.

With either 401(k) you can avoid RMDs while working as long as you own less than 5% of the business. Of course, this means if you are self employed you WILL have to take RMDs even as you contribute. Oddly, this can make sense as the article linked to below illustrates.